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 Financial Happenings Blog 
Wednesday, August 16 2006

Financial services is a funny industry.  It is an industry where the participants somehow decide that they are smarter than the great thinkers - the Nobel prize winners - in financial economics.

Merton Miller (Nobel prize winner) explained why the expected return of an investment has to be linked to risk; why there are no free lunches.  And yet many people in the industry still promote low risk ways of earning a high return.  They simply don't exist, people are too selfish to give away a return higher than they need to - so the return will always be related to the risk.

William (Bill) Sharpe (Nobel prize winner) explained that they best way to earn a return above the cash rate was to expose some percentage of your portfolio to the sharemarket, in a broad and diversified way.  The sharemarket provided a 'market risk premium', that is a higher rate of return over the long term for people who invested in it.

Markowitz (Nobel prize winner - do you notice any pattern?) said that an investor should use diversification to minimise the amount of volatility (ups and downs) in their portfolio, to try and get a smoother return over time.

So there you have it.  The fundamentals of investment success from some of the great thinkers:

  • If you want a higher return than a cash investment, expose some of your wealth to higher risk, higher return sharemarket investments.
  • Don't look for shortcuts - risk and return are related, so high return must mean high risk.
  • Diversification is an investors friend - use it to minimise the ups and downs of your portfolio.

 

Posted by: Scott Francis AT 07:17 pm   |  Permalink   |  Email
 
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